The time might be right to take a shine to gold funds

— -- Not too long ago, people who warned about the collapse of the banking system were called doom-and-gloomers. Nowadays, they're called central bankers.

If you're among the ranks of the petrified, you should consider investing in gold. But don't go overboard: A portfolio too heavily weighted with gold can sink like lead.

Gold has a special place in monetary history not only because it's beautiful, but because it's rare, it doesn't rust, and it's easily portable. In short, it's a perfect metal for currency.

In these days of paper money, gold has become best known as an inflation hedge. When paper dollars decrease in value, people put their trust in real assets, such as gold. When gold hit $850 an ounce in 1980, consumer prices were soaring at 12.5% a year.

Gold soared to $858 an ounce Thursday from a low of $712 an ounce in October — which is peculiar, because inflation has been deader than King Tut's grandmother. The consumer price index, the government's main gauge of inflation, fell 0.7% in December on a seasonally adjusted basis. It rose just 0.1% for all of 2008, according to the Bureau of Labor statistics.

Even more peculiarly, gold has soared while the value of the U.S. dollar has risen. Normally, the two move in opposite directions.

What gives? In a word: fear.

Although gold is an inflation hedge, it's also a catastrophe hedge. During the Civil War, for example, traders would sell greenbacks on news of a Confederate victory, and buy gold. They didn't want to get caught holding worthless U.S. paper money.

Although the nation is far from civil war, the economic system is profoundly stressed. Credit is still tight, even though the Federal Reserve has dropped the key fed funds rate from 5.25% in 2006 to somewhere between zero and 0.25% today. Wall Street is terrified that banks will continue to roll out massive losses. "The banking and financial system is deteriorating," says Joe Foster, portfolio manager for Van Eck International Global Investors Gold fund.

In short, it's a perfect time for gold, Foster argues. Even though prices are flat or falling, fear of economic collapse has been propelling the yellow metal higher.

The government's response to the economic downturn — pumping up to $1 trillion into the economy and pouring another $750 billion into the banking system — could also be a boon for gold.

"People are worried about the sheer amount of liquidity being pumped into the system," says Mark Johnson, manager of USAA Precious Metals and Mining. "They're worried about what that means for inflation later on," Johnson says. He figures that gold could break through its previous intraday high of $1,032.70 as inflation fears mount.

Frank Holmes, portfolio manager of U.S. Global Investors Gold Shares userx, says there's a supply and demand factor as well: Gold supply from South African mines is steadily dwindling, while jewelry demand in India and China is growing.

Most gold mutual funds invest in stocks of gold-mining companies. Typically, when gold bullion prices rise 10%, gold stocks rise 20% or 30%. Think of it this way: Suppose you own a gold mine, and you can produce gold for $600 an ounce. When gold sells for $700 an ounce, your gross profit is $100 an ounce. If the price of gold rises 14%, to $800, however, your mine's profits will double.

Gold stocks and gold mutual funds are the best way to go if you want to get the biggest pop from gold. But you'll also run the risk of the heart-stopping losses that gold stocks often produce.

If that kind of volatility worries you, you might consider investing in StreetTracks Gold ETF gld, an exchange traded fund that invests in gold bullion. Each share is worth 1/10th of an ounce of gold, less expenses.

But if you're really worried about an economic collapse, you'll probably want to buy gold bullion coins. If your grocer won't accept paper dollars for a loaf of bread, he certainly won't accept mutual fund shares.

Gold bullion coins, such as the U.S. gold eagle, don't need to be assayed for purity. If times are really hard, you can cut them into pieces — or bits — for smaller purchases. (This is where the expression "two bits" comes from.) You can buy eagles from coin dealers. It pays to shop around, however: Prices can vary from dealer to dealer.

The problem with gold coins, of course, is that you have to store them somewhere. Unless you're seriously worried about the end of the world, a bank safe-deposit box will do.

But gold shouldn't be used as a core investment. It's an insurance policy against financial ruin. "It's like a homeowner's policy," says USAA's Johnson. With luck, you'll never need your homeowner's insurance — and you'll never get rich from gold.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. new book,Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com.